Quiz Chapter 6

Which of the following statements is CORRECT, other things held constant? Select one: a. If companies have fewer good investment opportunities, interest rates are likely to increase. b. If individuals increase their savings rate, interest rates are likely to increase. c. If expected inflation increases, interest rates are likely to increase. d. Interest rates on all debt securities tend to rise during recessions because recessions increase the possibility of bankruptcy, hence the riskiness of all debt securities. e. Interest rates on long-term bonds are more volatile than rates on short-term debt securities like T-bills.

c. If expected inflation increases, interest rates are likely to increase.

What could be said about current interest rates? Select one: a. Interest rates while currently low, are still higher that experienced in the early 80's b. The FED has recently increased interest rates to fight the coronavirus c. Interest rates have been historically low for about 12 years d. Interest rates have recently increased because China dominates the world economy

c. Interest rates have been historically low for about 12 years

Suppose the real risk-free rate is 3.00%, the average expected future inflation rate is 2.60%, and a maturity risk premium of 0.10% per year to maturity applies, i.e., MRP = 0.10%(t), where t is the years to maturity. What rate of return would you expect on a 1-year Treasury security, assuming the pure expectations theory is NOT valid? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average. Select one: a. 4.62% b. 4.96% c. 6.04% d. 5.70% e. 6.67%

d. 5.70% Real risk-free rate, r* 3.00% Inflation 2.60% MRP Years: 1 Per year: 0.10% 0.10% 1-year bond yield: rRF = r* + IP + MRP 5.70% The correct answer is: 5.70%

Suppose 1-year T-bills currently yield 7.00% and the future inflation rate is expected to be constant at 4.50% per year. What is the real risk-free rate of return, r*? Disregard any cross-product terms, i.e., if averaging is required, use the arithmetic average. Select one: a. 2.03% b. 2.70% c. 2.13% d. 2.60% e. 2.50%

e. 2.50% 1-year T-bill rate 7.00% Inflation 4.50% Difference = real risk-free rate, r* 2.50% The correct answer is: 2.50%

An upward-sloping yield curve is often call a "normal" yield curve, while a downward-sloping yield curve is called "abnormal." Select one: True False

True

Suppose the real risk-free rate is 4.20%, the average expected future inflation rate is 6.50%, and a maturity risk premium of 0.10% per year to maturity applies, i.e., MRP = 0.10%(t), where t is the years to maturity, hence the pure expectations theory is NOT valid. What rate of return would you expect on a 4-year Treasury security? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average. Select one: a. 13.54% b. 11.10% c. 8.77% d. 10.21% e. 10.88%

b. 11.10% Real risk-free rate, r* 4.20% Inflation 6.50% MRP Years: 4Per year: 0.10% 0.40% Yield on t-year T-bond = r* + IPt + MRPt 11.10% The correct answer is: 11.10%

Which of the following factors would be most likely to lead to an increase in nominal interest rates? Select one: a. Households reduce their consumption and increase their savings. b. A new technology like the Internet has just been introduced, and it increases investment opportunities. c. There is a decrease in expected inflation. d. The economy falls into a recession. e. The Federal Reserve decides to try to stimulate the economy.

b. A new technology like the Internet has just been introduced, and it increases investment opportunities.

Which of the following statements is CORRECT? Select one: a. The yield on a 3-year Treasury bond cannot exceed the yield on a 10-year Treasury bond. b. The yield on a 2-year corporate bond should always exceed the yield on a 2-year Treasury bond. c. The yield on a 3-year corporate bond should always exceed the yield on a 2-year corporate bond. d. The yield on a 10-year AAA-rated corporate bond should always exceed the yield on a 5-year AAA-rated corporate bond. e. The following represents a "possibly reasonable" formula for the maturity risk premium on bonds: MRP = -0.1%(t), where t is the years to maturity.

b. The yield on a 2-year corporate bond should always exceed the yield on a 2-year Treasury bond.

Which of the following statements is CORRECT? Select one: a. The higher the maturity risk premium, the higher the probability that the yield curve will be inverted. b. The most likely explanation for an inverted yield curve is that investors expect inflation to increase. c. The most likely explanation for an inverted yield curve is that investors expect inflation to decrease. d. If the yield curve is inverted, short-term bonds have lower yields than long-term bonds. e. Inverted yield curves can exist for Treasury bonds, but because of default premiums, the corporate yield curve can never be inverted.

c. The most likely explanation for an inverted yield curve is that investors expect inflation to decrease.

Niendorf Corporation's 5-year bonds yield 9.50%, and 5-year T-bonds yield 4.80%. The real risk-free rate is r* = 2.75%, the inflation premium for 5-year bonds is IP = 1.65%, the default risk premium for Niendorf's bonds is DRP = 1.20% versus zero for T-bonds, and the maturity risk premium for all bonds is found with the formula MRP = (t - 1) 0.1%, where t = number of years to maturity. What is the liquidity premium (LP) on Niendorf's bonds? Select one: a. 2.63% b. 3.54% c. 3.05% d. 3.50% e. 4.10%

d. 3.50% Basic equation: r = r* + IP + MRP + DRP + LP. Years to maturity: 5 MRP In both bonds, so not needed in this problem 0.40% IP In both bonds, so not needed in this problem 1.65% r* In both bonds, so not needed in this problem 2.75% rNie 9.50% rT-bond 4.80% DRP Included in corp. only 1.20% LP = rNie - rT-bond - DRP 3.50% The correct answer is: 3.50%